A recent article in The Tax Adviser discussed the tax consequences of discharge of
business real property indebtedness (see Zimmerman,
“Discharge
of Indebtedness on Principal Residences and
Business Real Property,” 42 The Tax Adviser 602 (September 2011)). But the article did not
address another situation that often arises in
today’s economic climate: a short sale of real
property held for investment, not for rental,
secured by a recourse note.

Example: Taxpayer T buys
investment land and a building for $1 million. She
puts no money down and assumes a recourse note for the
full amount. She does not attempt to rent the property
but instead holds it with the intention that it will
appreciate in value over time. When the property’s
value declines to $600,000, T enters into a short sale for the
property’s fair market value. T has made no
principal payments on the note. She has cancellation
of indebtedness (COD) income of $400,000 and a capital
loss of $400,000.

If the note is
nonrecourse, Twill be
treated as selling the property for $1 million with no
COD income. Hence, there will be no tax consequences
with a nonrecourse note.

There are no relief
provisions for recourse debt in these circumstances
unless T is in title 11 bankruptcy (Sec.
108(a)(1)(A)) or insolvent (Sec. 108(a)(1)(B)). Note
that if she had attempted to rent the property, it
could qualify as business real property and thus would
be eligible for the exclusion of Sec.
108(a)(1)(D).

Under Sec. 108(a)(1)(D), a taxpayer other than a
C corporation may exclude a discharge of qualified
real property business indebtedness from income. For
purposes of this exclusion, courts have held that
the rental of a single property may qualify as a
trade or business if the taxpayer is actively
involved in the rental of the property.

Note that this result could possibly be achieved
even if T was unable to actually rent the property. The
Seventh Circuit ruled in Cabintaxi, 63 F.3d 614 (7th Cir. 1995), that it is not
necessary to have any gross receipts to be in a
trade or business as long as there are a bona fide
business motive and sincere efforts to engage in a
business.

A number of taxpayers currently find themselves
in the unfortunate circumstance of holding
investment real property, purchased with a recourse
note, that is sold short. Perhaps Congress could
extend the provisions of Sec. 108(a)(1)(D) to
investors who hold the property with the sole
intention of having it increase in value. Thus,
property held for the production of income, as
defined in Sec. 212, would qualify for the
exclusion. Alternatively, Congress could enact a
provision that would allow taxpayers in these
circumstances to show the loss as ordinary. Thus,
the COD income would be offset by an ordinary
loss.

A taxpayer who currently holds property for the
production of income that has decreased in value
below its adjusted basis can convert it to a rental
property and have it classified under Sec. 1231 as
property used in a trade or business. Provided that
the conversion is truly for the intent of rental, a
subsequent short sale will qualify for the exclusion
under Sec. 108(a)(1)(D). Moreover, the taxpayer will
not be required to reduce the property’s depreciable
basis upon conversion. The requirement that a
property’s basis for depreciation be reduced to its
fair market value when lower than the adjusted basis
upon conversion applies only to personal use
property. Regs. Sec. 1.167(g)-1 makes clear that the
basis reduction does not apply to property held for
the production of income that is converted to
business use. Similarly, the corresponding loss
recognition provision in Regs. Sec. 1.165-7(a)(5)
that restricts losses on the sale of personal use
property converted to property used in a trade or
business does not apply to property held for the
production of income that is converted to business
use.

EditorNotes

Michael Koppel is with Gray,
Gray & Gray, LLP, in Westwood, MA.

For
additional information about these items, contact
Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of
or associated with CPAmerica International.

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